TOTM alumnus Todd Henderson recently pointed me to a short, ten-question interview Time Magazine conducted with Nobel prize-winning economist Daniel Kahneman. Prof. Kahneman is a founding father of behavioral economics, which rejects the rational choice model of human behavior (i.e., humans are rational self-interest maximizers) in favor of a more complicated model that incorporates a number of systematic irrationalities (e.g., the so-called endowment effect, under which people value items they own more than they’d be willing to pay to acquire those same items if they didn’t own them).
I’ve been interested in behavioral economics since I took Cass Sunstein’s “Elements of the Law” course as a first-year law student. Prof. Sunstein is a leading figure in the “behavioral law and economics” movement, which advocates structuring laws and regulations to account for the various irrationalities purportedly revealed by behavioral economics. Most famously, behavioral L&E calls for the imposition of default rules that “nudge” humans toward outcomes they’d likely choose but for the irrationalities and myopia with which they are beset.
I’ve long been somewhat suspicious of the behavioral L&E project. As I once explained in a short response essay entitled Two Mistakes Behavioralists Make, I suspect that behavioral L&E types are too quick to reject rational explanations for observed human behavior and that they too hastily advocate a governmental fix for irrational behavior. Time’s interview with Prof. Kahneman did little to allay those two concerns.
Asked to identify his “favorite experiment that demonstrates our blindness to our own blindness,” Prof. Kahneman responded:
It’s one someone else did. During [the ’90s] when there was terrorist activity in Thailand, people were asked how much they’d pay for a travel-insurance policy that pays $100,000 in case of death for any reason. Others were asked how much they’d pay for a policy that pays $100,000 for death in a terrorist act. And people will pay more for the second, even though it’s less likely.
This answer pattern is admittedly strange. Since death from a terrorist attack is, a fortiori, less likely than death from any cause, it makes no sense to pay the same amount for the two insurance policies; the “regardless of cause” life insurance policy should command a far higher price. So maybe people are wildly irrational in comparing risks and the value of risk mitigation measures.
Or maybe, as boundedly rational (but not systematically irrational) beings, they just don’t want to waste effort answering silly, hypothetical questions about the maximum amount they’d pay for stuff. I remember exercises in Prof. Sunstein’s class in which we were split into groups and asked to state either how much we’d pay to obtain a certain object or, assuming we owned the object, how much we’d demand as a sales price. I distinctly recall thinking how artificial the question was. Given the low stakes of the exercise, I quickly wrote down some number and returned to thinking about what I would have for lunch, what was going to be on Sunstein’s exam, and whether I had adequately prepared for my next class. I suspect my classmates did as well. Was it not fully rational for us to conserve our limited mental resources by giving quick, thoughtless answers to wholly hypothetical, zero-stakes questions?
If so, then there are two possible reasons for subjects’ strange answers to the terrorism insurance questions Kahneman cites: Subjects could be wildly irrational with respect to risk assessment and the value of protective measures, or they might rationally choose to give hasty answers to silly questions that don’t matter. What we need is some way to choose between these irrational and rational accounts of the answer pattern.
Perhaps the best thing to do would be to examine people’s revealed preferences by looking at what they actually do when they’re spending money to protect against risk. If Kahneman’s explanation for subjects’ strange answers were sound, we’d see people paying hefty premiums for terrorism insurance. Profit-seeking insurance companies, in turn, would scramble to create and market such risk protection, realizing that they could charge irrational consumers far more than their expected liabilities. But we don’t see this sort of thing.
That suggests that the alternative, “rational” (or at least not systematically irrational) account is the more compelling story: Subjects pestered with questions about how much hypothetical money they’d spend on hypothetical insurance products decide not to invest too much in the decision and just spit out an answer. As we all learn as kids, you a ask a silly question, you get a silly answer.
So again we see the behavioralist tendency to discount the rational account too quickly. But what about the second common behavioralist mistake (i.e., hastily jumping from an observation about human irrationality to the conclusion that a governmental fix is warranted)? On that issue, consider this portion of the interview:
Time: You endorse a kind of libertarian paternalism that gives people freedom of choice but frames the choice so they are nudged toward the option that’s better for them. Are you worried that experts will misuse that?
Kahneman: What psychology and behavioral economics have shown is that people don’t think very carefully. They’re influenced by all sorts of superficial things in their decisionmaking, and they procrastinate and don’t read the small print. You’ve got to create situations so they’ll make better decisions for themselves.
Could Prof. Kahneman have been more evasive? The question was about an obvious downside of governmental intervention to correct for systematic irrationalities, but Prof. Kahneman, channeling Herman “9-9-9” Cain, just ignored it and repeated his affirmative case. This is a serious problem for the behavioral L&E crowd: They think they’re done once they convince you that humans exhibit some irrationalities. But they’re not. Just as one may believe in anthropogenic global warming and still oppose efforts to combat it on cost-benefit grounds, one may be skeptical of a nudge strategy even if one believes that humans may, in fact, exhibit some systematic irrationalities. Individual free choice may have its limits, but governmental decisionmaking (executed by self-serving humans whose own rationality is limited) may amount to a cure that’s worse than the disease.
Readers interested in the promise and limitations of behavioral law and economics should check out TOTM’s all-star Free to Choose Symposium.